September 25, 2024

Private Equity Investments in Germany - The Human Capital Aspect

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At A Glance

Employee Representation and Legal Implications: German employment laws, including those affecting works councils and supervisory boards, significantly influence corporate governance, and can affect private equity deal structures and timing. Employee representatives have statutory rights that can affect management decisions, and may necessitate early communication strategies.

Executive Retention and Compensation: Retaining key personnel is crucial for private equity funds, requiring competitive compensation packages aligned with fund goals. Legal due diligence should focus on existing executive contracts to develop effective retention strategies and ensure tax efficiency and enforceability.

Post-Closing Reorganization and ESG Considerations: Post-closing reorganizations must consider German employment laws and potential restructuring costs. Legal HR due diligence is essential to identify personnel-related issues and to ensure compliance with ESG criteria, particularly in light of upcoming non-financial reporting requirements.


Introduction to HR Risks in PE Investments

Private equity (PE) investments in Germany present unique challenges and opportunities, particularly from a human resources (HR) perspective. The intricacies of German employment, benefits, and labour relations laws necessitate careful consideration of various HR-related aspects to manage risks and optimize deal value. Key areas of focus include employee representation, employment law implications for the deal structure and timing, executive/employee retention strategies, post-closing reorganization aspects, legal due diligence, and environmental, social, and governance (ESG) considerations.

Employee Representation and Participation

In Germany, employee representatives play a significant role in corporate governance. Works councils, for instance, can be established in business operations with as few as five employees. Additional layers of works councils can be found at company and group level. Companies or groups of companies with an attributable headcount of more than 500 employees must set up a supervisory board, of which one-third of the members must be elected by the employees. In companies or groups of companies with more than 2,000 employees, half of the supervisory board members must be employee representatives, including some who may be proposed by the trade union. Employees also have constitutionally guaranteed rights to unionize and choose industrial action to push for better working conditions. For example, employee representatives have statutory information rights, in connection with proposed changes to the business or headcount reduction plans, and may influence management decisions. They may also seek to establish collective agreements that protect jobs or which guarantee site operations, potentially creating roadblocks for PE funds' value creation plans. To mitigate these risks, PE funds should develop communication strategies to address employee representatives' concerns early in the deal process.

Employment Law Implications for Timing and Structuring of a Deal

While PE transactions are often driven by tax optimization and financing considerations, there are a number of employment law issues that can significantly impact the timing and structure of a deal. This is especially true for the planning and execution of pre-closing steps in PE transactions, particularly in carve-out scenarios where the target is to be run as a standalone business post-acquisition. Pre-closing steps may include legal and operational carve-outs from the seller's organization and securing sufficient sourcing for the acquired business. Co-determination rights of employee representatives can necessitate time-consuming procedures, and statutory rules on the automatic transfer of employees can affect personnel costs and the post-closing business model. PE investors should aim to understand these implications early, and develop creative solutions to secure the success of their investments. These employment law risks must be carefully analyzed and addressed in transaction documents.

Strategies for the Retention of Executives and other Key Employees

Retaining the target's incumbent management team is often a priority for PE funds. Competitive executive compensation packages that align executives' interests with the fund's goals are crucial. In Germany, these packages typically include incentives based on the company's value appreciation. Key considerations for executives include avoiding "dry/phantom income," achieving capital gains treatment, and minimizing personal financial risk. The terms of management participation, such as leaver clauses and vesting provisions, must be carefully drafted to ensure tax efficiency and enforceability under German law. HR due diligence should focus on existing contractual arrangements with executives, including change-of-control clauses and severance packages, to develop smart retention solutions and commitments.

Post-Closing Reorganization Plans

Post-closing reorganization plans by PE funds can have significant implications under German employment law. Common reorganization measures include mergers, carve-outs, and intra-group agreements which may trigger collective agreements containing job protections or site guarantees. These measures can result in increased restructuring costs and liabilities for shareholders. Additionally, changes in employee headcount due to reorganizations can affect the structure of employee representation bodies at both national and international levels. The HR workstream must anticipate these consequences and contribute to a sophisticated post-closing concept as part of the PE deal.

Legal Due Diligence and ESG Considerations

Legal HR due diligence is critical in identifying personnel-related issues that could impact the PE business model. This includes assessing collective agreements that may restrict post-closing restructuring options, identifying hidden liabilities that could affect cash flow or balance sheets, and reviewing contractual arrangements with executives.

Investors' ESG parameters also play a role in HR due diligence. PE funds must ensure that the target meets ESG criteria, particularly those regarding human rights, diversity & inclusion, workplace safety, and industrial relations. In light of the Corporate Sustainability Reporting Directive (CSRD) that is going to be implemented at the national level from 2025, a growing number of German companies will be subject to non-financial reporting, which also requires detailed disclosures on social and governance factors.

Conclusion

In summary, managing HR-related risks in PE investments in Germany requires a comprehensive understanding of employee representation rights, employment law implications, executive retention strategies, post-closing reorganization challenges, and legal due diligence with a focus on ESG considerations. By addressing these aspects proactively, PE funds can optimize deal value and navigate the complexities of the German regulatory environment effectively.

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